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October 18, 2021 | San Diego | In this edition of The Institutional Risk Analyst, we speak with Stanley Middleman, Founder and CEO of Freedom Mortgage, about the US economy and the outlook for residential mortgages as we head into 2022. We’ve been fortunate to speak with Stan over the years about a range of issues that span his three decades as a mortgage banker and successful entrepreneur. Today Freedom is one of the top government lenders and issuers of Ginnie Mae MBS. Freedom operates in multiple channels, from wholesale to retail to correspondent and a national call center. They are also a leading mortgage servicer and among the savviest investors in whole loans and mortgage servicing rights (MSRs) in the industry.
The IRA: Thanks for taking the time, Stan. We recently wrote in National Mortgage News about what seems to be an inevitable slowdown in the industry after an extraordinary 18 months. You remain pretty bullish, especially in terms of your call to us years ago about this strong housing cycle extending through 2025 or longer. Set the stage for us as we head into 2022.
Middleman: You never know what’s going to happen because everything is unique in and of itself. Short-term predictions are a bad idea. What we do know, however, is that property values have been going up at an astronomical rate. One could contend that this cannot continue. But there is a long-tested rule in the mortgage industry that the peak of the last housing cycle is probably the trough for the next cycle. I think we have passed the previous peak, but there is a good bit more room for home price appreciation.
The IRA: You said to us last year that 2019 would be the floor for the next correction. Is that still the right way to think of this cycle in terms of home prices?
Middleman: We seem to be headed for several more years of home price appreciation. This is not an unreasonable assumption, since we have a shortage of inventory in terms of new home construction, especially affordable housing for new families. At some point, new supply will enter the market to satiate some of the extraordinary demand we have seen. Property values will continue to rise in the meantime and eventually supply and demand will meet, then supply will exceed demand, and then we’ll have a significant correction in home prices.
The IRA: We’ve had a dearth of growth in terms of home construction and also credit growth in 1-4s since 2008. We did not really see any growth in mortgage credit until a decade later 2018. Is this just part of a normal cycle?
Middleman: Yes, it always happens this way after a major housing correction. When was the last time we saw this kind of slump in creating new housing supply? The S&L crisis and the cleanup by the Resolution Trust Corp, which dampened activity for a decade. From the end of the 1980s right through until the early 2000s, we were in a major housing slump in terms of both credit and new home construction. Housing slumps can last for a long time, but then they tend to rise sharply for equally long periods once pent-up demand accumulates. We see that fact operating today with millennials coming into the home purchase market. As prices rise, buyers and investors jump into the fray. Then somebody gets the bright idea of building more homes. It is not a matter of if we’ll see new home supply, but when we will satisfy demand and from what sources.
The IRA: Where does the supply come from in this market? There are so many obstacles to building new affordable homes in major metro areas.
Middleman: One way to satiate the demand for residential housing is conversions of urban office space. Demand for office space in major metro areas is going to drop gradually over the next few years as leases are not renewed. I expect to see conversions of urban office space to an unprecedented degree. The falling demand for commercial office space of all descriptions will intersect with the demand for affordable housing in major cities. Then the economics will eventually work itself out in terms of valuations for these heretofore commercial assets.
The IRA: Residential use generates a fraction of the income that a commercial office building supports. The depreciation of commercial office property is going to cause serious fiscal problems for major cities. Urban centers such as New York or Chicago cannot survive on residential use and tourism alone. Without a commercial heart, these legacy cities will require ongoing subsidies that dwarf the level of federal support during COVID.
Middleman: Looking at trends in our industry, restructuring in urban office space is inevitable. As the price of unused commercial office properties falls, eventually new investors will come forward and convert these properties to other uses. This change is several years out and will take years longer, but we cannot go back to the days of pre-COVID business practices. We employ 10,000 people at Freedom. Many of them will never go back to a central office. Layer that change across the entire mortgage industry and then across other sectors of the economy. This change in business practices is going to result in reductions in the value of office buildings, which in turn will fuel conversions.
The IRA: Your view goes directly contrary to the happy narrative about the rebound of the cities, but we completely agree. Cities like New York, San Francisco and Chicago cannot survive without a strong business base, but that is not a fashionable notion in today’s world.
Middleman: Change is already visible in New York, Chicago, San Francisco and LA. It’s everywhere. If the shift to flexible work patterns is permanent, and I think it is, then the hybrid work model implies a lot of changes in how we work and where we work. And by the way, the hybrid model is more productive – by a huge margin. You are adding a couple of hours back to peoples’ days and improving their quality of life, family life, everything. How does this play out in residential housing markets? It is one more reason why I think that the scarcity of both urban and suburban housing will continue until at least 2025 or 2026.
The IRA: What I hear you saying is that the losses in commercial office real estate valuations have already occurred but will take years to recognize. Is that fair?
Middleman: Commercial office and residential markets are very different. Commercial restructurings move at a glacial pace, but there will be growing pressure on lenders and building owners to defend or improve the income from these assets. Meanwhile, the increase in prices in residential properties will result in a widening of the credit box to compensate. We already see many changes in Washington to that end. Moves to improve access to credit will drive prices even higher. You’ll see people flipping properties and making money. The home flipper TV shows will drive this trend, pushing prices even higher. We’ll start to see a wider and wider credit funnel because people want the party to continue. This will go on for several more years, but then we’ll see a significant correction.
The IRA: There are a number of issuers that are already offering loans above the conforming limit in anticipation of a significant increase in the maximum loans size by Fannie Mae and Freddie Mac. But we are not supposed to call this a bubble. Charles Kindleberger, the noted MIT economic historian, describes a financial bubble as an “upward price movement over an extended range that then implodes.” In other words, a bubble can be identified only after it has burst. How do you see the wider market environment for housing and the broader economy?
Middleman: Feeding into the credit equation are factors like the dollar, which is quite strong and attracts capital to our markets. You’ll see an infrastructure bill of some sort come out of Congress, though I have no idea what the number will be. There will be more taxation and more spending on non-accretive activity, which does not really support GDP growth. Unemployment will eventually move higher as growth slows and employers cut costs. Put that all together and we’re going to see lower interest rates down the road. The Fed will be forced to stimulate the economy again. And when unemployment rises and rates fall, we’ll see higher lending volumes—higher than is now reflected in most industry estimates. Maybe not in 2022, but in 2023 and beyond.
The IRA: Investors had no trouble financing a $2 trillion build in the Treasury’s general account last year, but now the public cash pile is down below $100 billion. Our view has been that even with a cessation in the purchases of MBS for the Fed’s balance sheet, it will be tough to get interest rates to rise much further.
Middleman: Wages are not keeping up with increased prices or even GDP growth, so it’s pretty safe to bet on continued easy policy from the Fed. Higher unemployment will force the Congress to provide more fiscal stimulus and will contribute to lower interest rates. In the medium term, I am still bullish on mortgage industry volumes.
The IRA: Are we headed into a period of consolidation in the mortgage sector? Is cost control and headcount reduction the next thing? The message from NAMB was that change is coming.
Middleman: I think you’ll see some tightening as interest rates rise in the short term. The industry will cannibalize one another for a while by cutting margins. We already see that happening in the wholesale channel. At Freedom, we don’t manage our business based upon volume, but rather on profitability. If we don’t like the price, then we don’t have to buy. We have a substantial book of business internally, so we can pick our opportunities or not.
The IRA: Going back to our earlier conversations, is this a replay of the late 1990s and early 2000s, when servicing assets were trading at 7x multiples of annual cash flow? This is your favorite part of the cycle, is it not?
Middleman: We saw great multiples in the 1990s, but today is not quite as high – at least not yet. Ask me that question in a year. We buy low and sell high. I was buying loans at cash positive numbers a couple of years ago. Now we increasingly see less attractive prices and multiples for MSRs, but still not quite to late 1990s levels.
The IRA: Given your view of interest rates and the economy, its sounds like asset prices are going to remain high and interest rates will remain low.
Middleman: If I am right about where interest rates eventually go, then that scenario will likely be correct. In every one of these cycles, like the early 1990s and the early 2000s, rates rose a bit before the economy slowed and rising unemployment forced interest rates back down. In 2003 and 2004, for example, we had an interest rate decline and the volumes in the industry surged to record levels. Some people thought that the party was over at that point. Ultimately these prognostications were wrong. The emergence of no-doc loans and other types of fringe products in the non-agency loan market kept the party going for several more years until 2007. Then we had a significant correction in home prices. I think we may be playing out a similar scenario today, but there are still years to go in the cycle.
The IRA: And just by coincidence, as 2021 ends, we are looking for decade-high volumes for private label loans. Thank you, Stan. See you in San Diego.